Blame the Bankers for Bad Corporate Behavior

In 2010, Carson Block pioneered the activist short-selling tactic of publishing detailed critiques of companies he considered frauds. His firm, Muddy Waters, helped puncture that era’s bubble of dubious Chinese companies that evaded scrutiny by listing their stock via shell companies on U.S. exchanges. Some five years later, Block started a hedge fund (by the same name) that applies the activist short strategy of publicly calling out the bad behavior of companies and individuals. Last month—at the KASE Learning Shorting Conference organized by investor Whitney Tilson—Block proposed a new moral initiative: Knock out Wall Street’s support for companies that significantly hurt the public. Shorts should call out the bankers, analysts, and fund managers who enable toxic businesses, said Block. Barron’s caught up with Block recently to ask him about his muscular version of investing according to environmental, social, and governance factors.

Carson Block: I put that Orient Paper report out there, and that opened the door to this wide world of China frauds listed in the U.S. The success of our Orient Paper report, and the next one on
Rino International
[ticker: RINO] created a bunch of competitors. We were all sprinting to expose these things.

Rino was delisted and its executives were barred after settling SEC fraud charges (without admitting guilt). Orient Paper disputed your accusations and the SEC closed the investigation with no enforcement action—but the company’s sales have eroded steadily.

After doing that for about two years, I realized that the conflicts of interest that enabled these frauds from China to list in the U.S. are really the same conflicts that pervade the stock market. So we started looking at companies outside of China. The dysfunctions caused by conflicts of interest and evil management exist everywhere.

You’ve had successes, and some high-profile disappointments—like your 2012 short of Singapore-based commodities firm
Olam International
(O32.Singapore).

They got bailed out multiple times by the investment company Temasek. The stock ultimately went up because of the bailouts. So we were right, but the short didn’t make money over the long term.

The vast majority of the things that we publicly short do go down over the medium and long term. We’ve got a track record that matches anybody’s on the long side, in terms of hit rates. And that’s during a 10-year bull market.

How do you operate today? Are you a conventional hedge fund?

Through 2015, we didn’t manage outside capital. Then in late 2015, I launched Muddy Waters Capital LLC, which manages private funds—otherwise known as hedge funds. The strategy is primarily an activist short-selling strategy. We’ve institutionalized the business. It is still a small firm. We manage about $200 million.

We still go public with our theses. But there have been developments in the past 8½ years that have made things a little bit more challenging. The human attention span hasn’t gotten longer. We used to be under the impression that people maybe read the first three to five pages of the report. These days, I don’t know if people even get through the first three to five sentences. So we made video reports for two of our shorts. You should check out the one on
OSI Systems
[OSIS] from December on our website.

Instead of presenting a new short idea at the KASE conference, you made a morality play.

Crusading shorts like yourself always appear to feel as if you are serving a moral purpose.

Most short theses are about companies that are hiding the ball from investors—so there are definitely crusading elements to exposing that. But the kind of companies that I’m thinking of for morality-based short campaigns are companies that traumatize people—not the investors who own them, but people that have no relationship to the stock. If we can effectively remove financial incentives and ensure that the perpetrators of egregious acts make less money than they hoped, then we are doing something good. Banks are going to look more skeptically at raising money for companies that could be doing things that are toxic. Analysts will be quicker to drop coverage.

So while activist short sellers have been very healthy for the market, and a force for good, this would have wider societal benefits than just keeping the market from getting dirtier than it already is.

Yes, there was a death at one of their facilities. That’s a situation where the brakes need to be applied and investors need to say, “I want to look into this. Maybe I shouldn’t own stock in a company that is operating so poorly.”

You also cited
Insys Therapeutics
(INSY), a maker of a synthetic opioid spray that literally killed patients who used it to overdose. You noted that Wall Street defended the stock even after Insys started to settle government lawsuits about the drug’s marketing, and as doctors and former employees were pleading guilty to kickback schemes that promoted the drug.

Insys agreed to settle a federal criminal investigation in August, and its former CEO just agreed to plead guilty to conspiracy and fraud.

I pointed to the past actions of these firms’ former employees, but I was never short either AAC or Insys. Their shares are in the dirt now, and I have no view on their current business practices, so I’m not saying that they are or aren’t shorts, here.

How does Wall Street enable bad behavior?

When the media reports on a company that has been doing something evil, the rationale usually given is the company’s pursuit of corporate profits. But that’s pretty nebulous. What is really happening is that the senior executives become fabulously wealthy on paper, because of their equity ownership. And in many cases they can monetize that ownership.

So if we’re in the capital markets buying the stock, we are providing the incentives for that bad behavior to continue. I don’t expect investors to know that a company is evil before it makes the news. But once it gets out there that this company could be doing something that is actually awful, investors have a moral obligation to really research it.

I don’t mean just call the management and ask them about it. Because if a management is doing something awful, then lying to you in a phone call is just a drop in the ocean. So, actually look into it.

Other steps in your moral activism program would involve reaching out to sell-side analysts and bankers?

This is really about the individuals, not the institutions. So once the market is on notice, a short activist should try to reach out to the buy-side people who control a position and reach out to the sell-side analysts. Appeal to them directly.

If I come away feeling like the person on the other end of the phone is basically in denial of the obvious—and that person doesn’t subsequently sell, or downgrade, the stock—then I think I should name that person publicly. I should say that I spoke to Joan Smith and showed her my evidence. She hasn’t sold the stock, and that’s a problem. She is enabling these guys to continue to be well-paid while they continue whatever bad acts I’ve accused them of doing.

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My goal in naming individuals is that some accountability be imposed on them. I hope that their family will come across these things on the internet and say, “Gee mom, I see here that you appear to be helping this evil company. Is that true?” Try explaining it to your kids.

We are talking about people who are acting legally; but we are trying to disabuse everybody of the illusion that their actions in the capital markets don’t add to these negative impacts. They do.

What sort of bad behavior would merit this kind of campaign?

Certainly not one-off kind of events, accidental, one rogue lower-level employee...but rather a harmful activity that a company’s business is predicated on. Then you have a moral obligation to sell, if you are long the stock. And if you are a sell-side analyst, you have a moral obligation to either take the Buy off the stock or drop coverage.

People criticize fossil-fuel companies, gun makers, cigarette companies, opioid makers—where is it important to go active?

Investing has always been amoral. To move investing from an amoral point to one where morality is occasionally applied as a filter, we have to start with the things that 90% to 95% of people in the investment industry would agree are evil. Fossil-fuel companies wouldn’t rise to that standard. Tobacco companies wouldn’t rise to that standard. But certain health-care companies would.

You have all of these health-care parasites that are out there ripping off the system or ripping off individuals. They are narrowing access to health care. And that is impacting people’s lives, because they can’t get access to necessary health care for themselves or their kids.

Or else companies whose corner-cutting results in serious injury or death. Those definitely rise to that level. We need to start with these practices where the vast majority of investors would agree that it is an evil behavior.

You mentioned AAC, now a micro-cap, and Insys, whose stock has dropped tenfold. Do you have any that you’re looking at now that might invite this activist approach?

Right now I’ve got nothing in the pipeline. But I certainly hope as a result of the presentation and the ensuing publicity that I start seeing some ideas along those lines.

I don’t think short investors have really been looking for those, unless there is a regulatory angle. And regulator-dependent short ideas are tough. A lot of times the argument that a regulator might care won’t move the longs to dump the stock.

How does this fill in the gaps in what’s already being done by environmental, social, and governance investing, the so-called ESG factors?

At the end of the day, ESG investing is long-oriented. And it is hard to go long a business whose profits come from acting egregiously and then want them to materially change the way that they do business.

In other words, most ESG funds will either buy or not buy a stock. They won’t short it or criticize it.

If your orientation is that of a short seller, then you have incentive to really push for reform. In the two cases that I cited, the businesses absolutely fell apart after there was regulatory action. But it’s pretty rare that you get such strong regulator action. That’s why shorts need to step up their moral activism.

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